Disappearing money

It’s probably happened once in your lifetime. You throw socks in the dirty clothes hamper and then wash and dry. When you fold the laundry you end up with missing socks. Where did they go?

You might feel the same about the disappearance of value from brokerage accounts or your home. Perhaps you purchased a business some time back and now its market value is lower. Where did that money or value go? This article discusses the implicit and explicit/intrinsic value of stock investments.

If you purchase a stock for $100 and then sell it for $50, you lose $50 in the transaction. Where did the $50 go? Intuitively you may posit that your loss flowed to the person who purchased the stock from you. Or perhaps you may think the company issuing the stock was $50 richer. You may even feel that your brokerage is $50 heavier. But no, the purchaser of the stock is not $50 richer and the stock issuing company did not profit from your loss. The brokerage is a bit richer, but only as a result of the transaction charge for selling your stock. I suppose then you really feel poorer by $50 plus the brokerage charge!

Of course these days you might have stock buyers relishing in their gains. It is imperative to understand that regardless of trend, supply and demand drive stock prices. The supply and demand components reveal more about our original question:

Where did the money go?

In our earlier example, the price of the stock fell because of a decrease in demand and perhaps more specifically, the investment community’s perception of the stock. Investors were only willing to bid $50 for your stock despite the fact that you bid $100 at some point in the past.

So an operative question might be, “why are investors only willing to bid $50 for something that I thought, and perhaps many other investors thought, was worth $100?” If we examine supply/demand factors, we could suggest that there is an increased volume of stock on the market now due to more share issuance by the company. Other things being equal, the increased supply should reduce the stock’s value. On the other hand, credit conditions may have tightened and investors cannot borrow money as readily from their brokerage or other sources. This credit tightening, again other things being equal, will reduce demand and hence the bid price for the stock.

If I can digress for a moment, I used to ask people at the peaks of the stock market in 2007 and 2000 what their plan was for cashing in their stock gains. My Investment Law #1 says,

Have a plan for taking profits.

Of course, the folks to whom I asked this question never considered an exit. They were simply happy to read their brokerage statements. Successful long-term investing requires systematic profit extraction. So if their brokerage statements indicated they had a $1,000 profit on a stock, I suggested their profit was implied. As a reference, those that have traded commodities are aware of IRS requirements of marking open futures positions “to the market” at year’s end. That means you have implied gains or losses. Those gains or losses do not become explicit until you cash out. When I told those folks that they weren't $1,000 richer, yet, they looked at me askance.

So in the stock example from earlier, if you purchased the stock originally for $100 and saw its value rise to $150, were you really $50/share richer? Well that was certainly the understanding since your implied gain was $50/share. That $50/share gain left you smiling but then when it came time to sell, the bids were only $50/share. Not only did you “lose” that $50/share gain, now you are coping with a $50/share loss from your original investment. So once again we ask ourselves,

Where did the money go?

The simplest explanation is to suggest that the money vanished into thin air or in reality never existed. Unlike your socks, which are probably somewhere in your house, the $50 you lost cannot be tangibly found in your sale transaction. Likewise when the stock fell from $150 to $100, the $50 in implied value lost cannot be assigned either.

The factors causing a stock price to rise and fall are largely based on investor perception, which might be based on revenues and earnings forecasts. These numerical calculations fall into the realm of “logical” perceptions and efficient markets. There is also another large component at work and that is investor emotion. Investors herd. This is a very natural human instinct that causes people to follow others if for no other reason than to be part of the crowd.

These investor perceptions, whether logically or emotionally based, create the implied value noted in our example. This is the interesting thing about money. On the one hand, money defines these implied values that are driven by investor perceptions. At the same time, money defines the very explicit values of the groceries we buy at the store (brand premiums aside). The price of eggs, butter, and milk, for example, are not as influenced by an implied value component. In large part, the price of these goods remains fairly steady. If for some reason, a group of people wanted to corner the market in butter, then the price of butter would reflect some implied value over which the price of butter should really be, or its explicit value.

If we go back to our stock example, there is an explicit value assigned to a company’s shares. This value is known as the accounting value or book value. If a company takes all its assets and subtracts its liabilities, we have the book value of the company. Divide this figure by the number of shares outstanding and you get the book value per share or its explicit value.

Let’s suppose a company has 1 billion shares outstanding and its stock price drops from $100 to $99. That price drop translates into an implicit loss of $1 billion in market value for the company. That does not necessarily mean the company actually experienced an explicit loss of $1 billion. That company has many other assets that were likely unaffected by a $1/share implied value reduction.

Whatever your thoughts may be about the current market run since 2009, it is fair to say there is a great deal of implied value. If you were fortunate enough to buy near the bottom in 2009, you are sitting on a ton of implied value. If you held on through the market trough, you may have regained some of the implied value you lost along the way. If you are a recent entrant to the market, you have purchased something with a great amount of implied value.

Implied value is powerful. If an individual has a stock portfolio with a large amount of implied value, that person may be considered quite wealthy. The same goes for owners of a publicly traded company. That sort of wealth may compel creditors to loan them money. This has its own peril since the collateral is full of implied value. This can be the topic of another article.

The stock market is a great example of implied value. Once implied value become less important than explicit or intrinsic value, the game changes and selling occurs. At moments of great stress, the selling becomes a panic and prices fall (a bunch of disappearing money). In another case, the selling occurs gradually and the money disappears less quickly.

What the market giveth, the market can taketh! Your gains are never really yours until you sell and take the cash. Now, where the heck is my other sock?

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Jim Mosquera is the author of Escaping Oz: Protecting your wealth during the financial crisis. The book discusses how the public will greatly misinterpret the capabilities of our financial Wizards and what they should do to shelter their investments. Jim is also the publisher of The Sentinel Financial Report, a monthly publication discussing economic and financial trends. Mr. Mosquera has developed financial trading software and holds B.S. and M.S. degrees in Industrial Engineering. Email Jim at this address or visit TheSentinel.biz.